Abstract:
The nature of the global economy is one of dynamic change. Shipping is a service
industry with its demand related to changes in international trade levels and
patterns. As a consequence shipping is subject to sometimes unpredictable swings
in demand so that the operator is required to make strategic planning decisions
while navigating through boom or bust environments. While boom economies
generate rising freight rates which are welcomed and encourage investment, ship
operators may also have to face falling freight demand and declining freight rates
that may have significant impact on profitability, often falling to uneconomic
levels for extended periods. In such a period of uncertainty and declining profitability
management will make operational decisions to reduce costs. However,
shipping lines operate in a market environment so any decisions made to rationalize
the trade may have significant long-term competitive implications. For
example, traditional micro economic theory might suggest that the prudent
strategy to adopt would be to close down the operation and reopen when the
market conditions improve. In a world of certainty or when costs of taking this
action are zero, this would be a valid strategy. However, because of fear of
competitors taking up a line's market share if the shipping company exits, even
temporarily, this strategy cannot be valued simply in terms of shut-down and
start-up costs. A further consideration is the fact that standard capital budgeting
techniques, such as Net Present Value (NPV), cannot incorporate the flexibility
to respond to new information and strategic responses explicitly into their
investment analysis. This paper will demonstrate the use of Real Option
Analysis (ROA) to provide guidelines for decisions about closing operations in
adverse market conditions.
